Saturday, April 11, 2009

Which Transactions are the Riskiest?

Medium sized, infrequent ones. That’s Bob Blakley’s conclusion in his post, The Zone of Essential Risk. An excerpt:

If you conduct infrequent transactions which are also small, you'll never lose much money and it's not worth it to try to protect yourself - you'll sometimes get scammed, but you'll have no trouble affording the losses.

If you conduct large transactions, regardless of frequency, each transaction is big enough that it makes sense to insure the transactions or pay an escrow agent. You'll have occasional experiences of fraud, but you'll be reimbursed by the insurer or the transactions will be reversed by the escrow agent and you don't lose anything.

If you conduct small or medium-sized transactions frequently, you can amortize fraud losses using the gains from your other transactions. This is how casinos work; they sometimes lose a hand, but they make it up in the volume.

But if you conduct medium-sized transactions rarely, you're in trouble. The transactions are big enough so that you care about losses, you don't have enough transaction volume to amortize those losses, and the cost of insurance or escrow is high enough compared to the value of your transactions that it doesn't make economic sense to protect yourself.

The chart below summarizes the problem:

Risk Zones

Blakley is talking about eBay transactions, but I think there is a loan underwriting parallel too. If you’re doing large transactions frequently, you probably have the staff and expertise to do them right. If you do large transactions infrequently, you probably are very focused on your execution and/or bring in the required expertise to help. If you only do a few small transactions you’re never going to lose much, and if you do a lot of small or medium size transactions you will both develop expertise, and an occasional miss will be spread over a large base. But, if you do infrequent medium size transactions you can get into trouble because you never develop the expertise and the transactions aren’t large enough to justify hiring experienced people to do them.

This could be an explanation of how community and small regional banks ran into trouble in the residential construction and land development segments.